Apple stock highlights challenge of valuing equities

Apple, Inc. is one of the most widely-held stocks in the world. But trying to figure out whether to buy its shares or sell it short is a case study in how hard it is to make intelligent investment decisions.

If you are looking for guidance, don’t look to Wall Street analysts for an answer because you get what you pay for. If you have ever paid for a Wall Street analyst’s report, I would be shocked. But if you follow what analysts said on Apple, you paid in another way – by buying a losing stock and forking over a commission to the broker who sold you the shares.

It all comes down to who pays the analyst. If the analyst is paid for the accuracy of his calls, odds are better that he will try to get it right. And that’s what one analyst did — according to the New York Times, Carlo Besenius, chief executive officer of Creative Global Investments, slapped a sell rating on Apple on October 3 when each share fetched $685. In December, Mr. Besenius cut his Apple price target to $420, and during the week of February 4, he cut it further to $320.

I am convinced that nobody can predict what a stock will do. If that were the case, then surely John Paulson — who famously made $4 billion in 2007 betting on a drop in subprime mortgage-backed securities — would be able to beat the market year after year.

But billionaire Mr. Paulson has failed in fairly spectacular fashion to do that over the last several years. For example, in 2012, Mr. Paulson suffered a 19 percent drop in his $19 billion Advantage Plus fund — during which time the S&P 500 rose 13.4 percent — after the same fund lost half its value in 2011.

So color me skeptical that any analyst or investor can regularly beat the market.

Nevertheless, it is interesting to look into how Mr. Besenius got Apple right last October. The first thing he did that separates him from the pack is that he started his firm with the idea that the only way he would get paid is if people bought his research because it made accurate predictions.

In doing that, he set himself apart from the competition, as most analysts do not charge investors directly for their research. Instead, those analyst reports are sales collateral, They are meant to encourage people to buy stocks to generate the commissions that finance the research.

So not surprisingly, about 88 percent of the 57 analysts who covered Apple still had buy ratings on it in November even as it plunged below its September 2012 high of $705, according to the Times.

Mr. Besenius got another thing right — he applied his own methods to come to an independent conclusion about Apple. Specifically, he applied two of the best known analyst tools: technical and fundamental analysis.

These two techniques are independent of each other. As Carter Worth at Oppenheimer explained to me in 2006, technical analysis attempts to predict stock prices by analyzing trends in their price and trading volume. For example, if a stock’s price is rising as trading volume increases, the price could continue to rise — but if the stock is inching up on declining volume, it could be near a top.

Fundamental analysts believe that a stock will rise if the company’s industry and competitive position are strengthening and will fall if one or both of those deteriorate. Such analysts also try to predict earnings for a quarter and to anticipate increases in revenue and profit growth rates.

Mr. Besenius made his sell recommendation based on technical and fundamental factors. On the technical side, “as Apple hit $700, [Mr. Besenius concluded that] its upward momentum and trading volume were slowing,” reports the Times.

And Mr. Besenius concluded that on the fundamentals, Apple’s competitive position was deteriorating due to “concerns about product quality and innovation, as well as growing competition from rivals like Samsung,” according to the Times.

Mr. Besenius was also uncomfortable with Apple’s arrogance under Steve Jobs. As Mr. Besenius told the Times, Jobs, “built a great company. But he was one of the most arrogant CEO’s I’ve ever met. The way he introduced new products was one big display of arrogance. He ridiculed Microsoft as ‘Micro who?’ That’s a good reason to be cautious. A little humility is a good thing.”

He is certainly right that Mr. Jobs was arrogant but I am surprised he mentioned this given that Mr. Jobs is no longer running Apple. Nevertheless, I agree with his other points about Apple’s fundamentals.

Moreover, hedge fund honcho David Einhorn’s effort to encourage Apple to disgorge some of its $137 billion in cash to investors through dividend-paying perpetual preferred shares seems to have contributed to boosting the stock from the $450 at which it traded at the end of January.

But perhaps Mr. Besenius’ $320 price target is a more accurate predictor of Apple’s trajectory. If Apple cannot find profitable and rapidly growing new markets in which to invest its cash to generate high shareholder returns, then disgorging the cash is a powerful signal that Apple’s best days are behind it.

And unlike most other analysts, it matters to Mr. Besenius whether his call is accurate. Unfortunately for Apple investors, there is no guarantee that he is right.